Terra Extraneus

The September 24 ,2009 warning by FINRA about leveraged and inverse ETFs was a bit annoying. If FINRA has to warn about it, should not there be new suitability rulemaking to go with it aimed at these products?

Even the explanation by FINRA of what these products are lacks clarity for the people FINRA is trying to warn. Of even more concern, however, is that these products, FINRA believes, are especially apt to act erratically in volatile markets.

FINRA’s explanation of these products contains nicknames like “short funds” and “ultra short funds,” as if the investor reading the alert that did not understand the more formal name might get something out of the less formal. Of course, FINRA has to start somewhere, and the name is the most logical place to start. But, what else is the investor likely to get beyond the names? Will the investor really understand the nature of these products and their real risks?

These products should probably be classified by FINRA for suitability purposes as “speculative,” if FINRA’s warning is to have any real meaning. That would go a long way toward diverting them from the unsophisticated. FINRA could also declare them unsuitable for retirement accounts. FINRA could also preclude margin account purchases of these products, or limit margin account purchases to margin accounts with an actual marked to market value exceeding one million dollars.

Unless FINRA begins these types of protective rule implementations, FINRA will always be regulating after the losses instead of preventing them.

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The New York Times reported on January 28, 2009 that JP Morgan conducted a “wide ranging review” of its hedge fund exposure. JP Morgan asked Bernard L. Madoff’s funds questions and did not like the answers. JP Morgan withdrew the money it invested in 2008, prior to the implosion caused by the discovery that Madoff was the greatest Ponzi-scheme offeror in history. But, JP Morgan did not tell its own customers about its experience with the Madoff-linked funds.

No doubt the personnel at JP Morgan that conducted the review, got the answers from the Madoff-linked funds, decided the answers were insufficient, and recommended fund withdrawals, rather than being given a corporate gold star by JP Morgan, will end up being used as cannon fodder while JP Morgan management tries to defend itself against its own unhappy customers that believe JP Morgan should have alerted them, too. JP Morgan will no doubt claim that there was a Chinese wall between its internal corporate investment advisors and its external fund managers. The managers of the funds of JP Morgan customers will no doubt claim they did not get the word from the internal corporate advisors.

The New York Times reported that JP Morgan got itself out of the Madoff-linked funds when the funds were reported to be up five percent while the broad market was down thirty percent. Also, the news report indicated that Madoff accounts were held at JP Morgan, in other words, Madoff was a bank customer, too. Was JP Morgan able to use what it learned from those accounts to protect itself but unwilling, or unable, to use that information to protect all of its customers?

It will be interesting to see whether JP Morgan gets sued in a claw back claim by the regulators. After all, the money JP Morgan withdrew was arguably not their money, but the money of some other dupe.

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Selling off, even in market “crash,” later called more accurately a “correction,” is usually driven by switching from the investment strategy based on company fundamentals to the strategy based on market timing. The market timing approach always fails because it is based on prophecy, only without God’s help. It fails because it is based on emotion, fueled by media language, and not business principles. It fails because it takes the investor out of the market just when opportunity, even in an inflated market, abounds.

A true market “crash” involved auction rated securities, which most people did not own. The regulators, for a change, made the issuers step up and buy the failed product back. This “recall” of a bad product made sense. Thus, that “crash” was defanged and the whole thing has all but fallen off the stage. If the regulators had not acted, the wirehouses would have turned it into a debacle because they were treating it as a sales practices violation by their own brokers. I compliment the regulators even though I was deprived of many years of gainful litigation employment.

This market down turn has the same lesson for investors all the others have had. Do not over concentrate. Diversify. Balance stocks (sometimes called equities) against other types of investments in a portfolio (bonds, CDs, mutual funds that are not themselves concentrated only in stocks) or against non-market investments like real estate. Read at least the first couple of pages of the prospectus to make sure the product, be it a mutual fund or whatever, does not over concentrate your portfolio. Do not rely only on your financial advisor to read it for you. Your financial advisor might need the commission that month, or might have been misled by the broker-dealer employing him or her. Most will do their best. When in doubt, get a second opinion from your Certified Public Accountant (except during tax season, when their attention is too divided). You should be in doubt enough to consult your CPA every two or three years even if you have a static portfolio, whether you think you need to be or not. Let your CPA scare you a little bit, even if you do not change anything. If they scare you a lot, rethink your strategy. Many persons who thought they might retire this year or next will regret not doing so.

Those of us that never gave up the concept of whole and universal life insurance still have cash value sitting there. While it might be at risk in a general depression, in every market “correction” I have lived through it has been “untouched.” It is just another diversification and another form of professional money manager, even if it is not a dramatic gainer. There may be better products to use, but I got in at a time in my life when I understood that product and did not understand the stock market, and it has always served me well.

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I hate to be pessimistic, but the United States Senators running for the Presidency of the United States are not businessmen, and never have been, and thus, the bailout will fail. For example, during the debate Tuesday night, Senator McCain claimed he was in favor of the bailout so there could be sources of credit for businesses, especially small businesses, so that they could borrow to make payroll. Senator Obama did not disagree.

Line up every banker and venture capitalist that wants to lend money to a business so it can make payroll. It will be a very short line. Usually, when any business is borrowing to make payroll, assuming such a thing can be done even in the best of times, the business is doomed. Apparently, both of our major party candidates will spend tax dollars even on the futile, or else, they do not know where the line of futility lies. I do not know which is more worrisome. It was like a scene from Doctor Strangelove, only about money.

Of course, Tom Brokaw is not a businessman. He did not remark on the error, if it was one. The studio audience had been sworn to silence, or else, were picked because they would not know enough to know better. Either way, the silence was “golden.”

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The demise of Bear Stearns and the bankruptcy of Lehman Brothers, followed by the purchase of Merrill Lynch by Bank of America, heralds the final end of the Wall Street business model.

B of A’s CEO claims that for seven years he predicted the commercial banks would end up owning the investment banks. Merrill’s CEO claims that this would be great for Merrill’s 16,000 registered representatives because they will have access to B of A’s customer base.

However, the bank owned model of broker dealers and the Wall Street model have been radically different. The banks have never been as tolerant of risk nor as tolerant of salesmanship. As a result, the banks have had a narrower range of products.

Merrill Lynch training and compliance has always been enviable in the industry. But, neither will be as necessary in the new world where banks dampen the sharp edges more than regulators. Banks like to charge fees and so many of the free services with which Merrill Lynch built its book of business will no longer be free. Banks like the wealthy and have very little to offer the non-wealthy (currently defined as someone with less than $500,000 of investable assets). Retail broker dealers liked everyone. It is interesting to see which business model failed.

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Investment News writer Darla Mercado reported that fixed and variable annuity sales by banks fells 4% in April and that for the third consecutive month, fixed annuities out sold variable. She quoted Jackson National Life Distributors, LLC as blaming the decline and the change in the mix of sales on “market volatility.”

It certainly could not be because consumers have figured out that for every nine well meaning and competent annuity sellers, there is one idiot, or fiend, on the loose using variable annuities to the detriment of their customers and attracted by commissions that are too high and consumers that are too gullible.

This is sad because variable annuities should be a good product. Why is it a poor product for the average consumer, especially consumers over 50?

Once the sale is made, banks, insurers and the financial services industry think they can turn their back on them. A variable annuity is like a car, it requires maintenance. The underlying funds and fund choices get out dated, hammered by the market or suffer from bad management, just like anything else. But, once sold, the only protection the consumer has from huge losses of principal is the selling agent. If the selling agent is an idiot, lacks worth ethic, or is perpetually on to the next big sale, the consumer is all alone with a product they do not have the tools to manage. Even some selling agents lack the tools to manage large numbers of these accounts and have to look at them manually in a disciplined manner.

I thought it was funny that Jackson National spoke out on the situation. I have a Jackson National product and it has lost 20% of principal and all earnings to date in the last quarter. This loss is purely market driven because I have one of the good agents and I litigate in this area for a living so I know something about it.

The other reason variable annuity products can be dangerous to older people is because the financial services industry uses terms that the consumer does not realize have meaning that will lead to unintended consequences. Everyone wants to be “moderate,” right? No one wants to be “speculating” or too “conservative” when it comes to financial risk. But, if the customer tells the securities industry that they are, indeed, a “moderate” investor, the customer is in reality telling the industry the customer is comfortable risking some principal loss, maybe as much as half.

Also, the term “growth” sounds like a good thing, right? Like “moderate,” to obtain growth means the acceptance of risk of principal. Most of the portfolios of elder customers I have reviewed, that is, persons well above retirement age, contained too much investment in “growth.” Most “growth” investments take at least five years to produce that “growth.” Most “growth” investments will fall at the same rate they rise. Very few “growth” investments are based on the stock issued by large corporate entities, but rather by the smaller and more vulnerable companies. But, too many customers move most of their principal into these products.
Fixed annuities on the other hand, too boring in good times, become more popular when the economics become uncertain.

It is amazing to me that organizations like AARP, the SEC, or the Congress, do not seem to recognize these defects. If the SEC would simply ban surrender charges or severely limit their use, variable annuities would not be the product of choice. If the SEC required an annual positions review in the variable account by the selling broker dealer, that might reduce the risk because supervisors would be forced to fill in the gaps left by the weaker members of their sales forces.

Market volatility should not be the only policeman on the street.

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For many years, every kid I knew that did not go to college was somehow located and drafted by some pyramid or outside sales company. They were each eager to make their initial presentations to family, friends, and friends of their parents. Thus, I sat through many presentations on vitamins, cleansers, vacuums, and other life essentials. I would listen and decline, or if there seemed to be any hope, listen and then dissuade.

People that are drawn to a life of sales have unique gifts both of personality and articulation. Most people simply do not have these gifts. Training can enhance these gifts, and help them emerge, but it does not seem often that they can be instilled and created. Thus, dissuading someone from the waste of struggling in a career in which they have little hope seems humane. All of the kids eventually left sales, no matter what I said or did not, and obtained an education, or found an otherwise suitable career.

The same may be said for opening and running a business - some people have what it takes and others do not. Moreover, a business is subject to so many factors that stress is existence, even the right person running it might not be enough.

Unfortunately, many people are willing to buy, even if it takes all of their life savings and more, based on a good sales presentation. Most buyers of franchises do not have CPAs and do not hire CPAs to look over the disclosures, contracts and projections. Most buyers do not have lawyers and do not hire lawyers to look at the contracts. Most buyers do not consult their professional financial advisors. At most, buyers of franchises will normally interview prior buyers without realizing they may be part of the hustle or themselves victims that have not yet figured it out.

There are many legitimate franchising operations. But, any business, including a franchise sold by a reputable company, requires capital, expertise, and experience to evaluate, customize, and implement. Even a knowledgeable buyer should get a second opinion.

In the internet age, no business is likely to be truly unique, even if it is the only one in a town or on a corner, and therefore, there is likely to be information available. Thus, industry associations, newsletters, and business writers will generally explore the trends in an industry to determine pricing trends, revenue trends, expense trends and resale trends. A new business that is projected to be more successful than regional and national averages of existing businesses is likely infected with a terminal case of optimism.

While owning a business is the quintessential American Dream, business failure is a pervasive reality. While owning a lawsuit about a failed business is not the American Dream, it is often the only way a buyer can recoup some of what was lost.

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One of my earlier experiences with advertising material regulation was the time the NASD refused to approve an advertisement by a registered representative that contained a cartoon with a caption that read “We put the boots on the bull.” The cartoon displayed a Texas longhorn wearing boots. The NASD’s refusal was that they could not determine from the cartoon and caption what expertise the registered representative was claiming. In other words, in past eras, NASD advertising materials regulation has largely been arbitrary and without substantive principles to guide it. The NASD seemed to have no trouble in that same era with Merrill Lynch’s logo which incorporated a bull (but not a Texas longhorn).

FINRA Regulatory Notice 08-27 seems to focus on the advertising materials created by ghost writers and professional advertisers designed to give the appearance of credentials based on book writing, article writing, and newsletters. Of course, while this might be a serious subject, it still does not address the real issue: what constitutes a “credential” for a registered representative?

The main worry of the FINRA Regulatory Notice seems to be that the ghost written materials imply the registered representative is the author “and therefore an expert.” I hate to break this too harshly to FINRA, but every registered representative claims to be an “expert.” What customer wants a registered representative that is not an “expert?” Of course, making the claim by creating false credentials or false marketing materials is fraudulent. Nevertheless, because the industry refused to definitively define what constituted a “credential,” and continues that proud tradition, claiming to be an expert will continue.

By the way, if one is searching for a ghost writer to create marketing materials for financial services to individuals, I have had the privilege to know a couple of the best. The disclaimer included in their materials that the financial executive is not the sole author of the materials is often overlooked by the prospective customer that wants to hear what they want to hear.

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During the inter-war generation in the Western democracies, the wealthy elites that arose created a generation of wastrels. That was the basis of the first hit television series starring Hugh Laurie (House), Wooster & Jeeves (BBC). Bertie Wooster (Laurie) was a young man who lived well on an allowance from his family money administered by his stern aunt. Jeeves, the practically omniscient “gentleman’s gentleman,” protected Wooster and his friends from themselves.

Apparently, we have created a similar group in the United States, and its spokesman is Timothy Sykes. In his self-published autobiography, An American Hedge Fund, Mr. Sykes tells his story of how during his high school years he became a day trader using his Bar Mitzvah money. By riding market volatility like a barroom mechanical bull, he turned $12,500 into a million or so. He managed to graduate from high school, even though, as he tells the story, he spent more time using the school’s Internet pipeline to trade than he did in class. He attended college at expensive private universities. He does not exactly admit that his parents were paying his living expenses while he was dodging class and day trading, but that seems to be the gist of it. He migrated to Tulane from the Northeast, and rather than majoring in either economics or business, he majored in philosophy. Throughout, his autobiography makes him sound like wastrel.

After college, and especially after day trading became too difficult for him to continue to derive profits, he engaged in short selling, and especially in the world of what he calls “micro-cap” stocks. He tried to get others to allow him to invest their money in what he labeled a “hedge fund,” but he ultimately failed to attract significant investors.

Sykes claims in his book that he failed to attract investors due to marketing restrictions on hedge funds. That has not stopped growth in that industry that has deserved so much comment, but it apparently did stop him. So, the title of his book is apparently a marketing ploy.

Like all authors, Sykes revealed his true reasons for failure: he had no true business education. He read hundreds of business books and, it seems, is claiming to have learned finance by reading in a log cabin with a candle. But he had no discipline or interest in actually taking classes in finance.

Another reason Sykes failed to create a hedge fund, and the reason he was nothing more than a day trader with an Internet account, is because while he was in high school and college, he did not understand what investing really meant. He thought it was a game, like a video game, or more like video poker. He saw the impact of the people cheating at the game: pump and dumpers, stock spammers, and chat room lounge lizards. Many of the stocks he worked with were nothing more than an idea looking for capital, or worse, just a scam. Sykes never saw the entrepreneur. Sykes never saw the small business. Over sixty thousand businesses in central Oklahoma alone employ five or fewer people.

Sykes says that he “immediately” (his own word) saw a trading opportunity in the destruction and death that rained on New York when airliners were turned into cruise missiles on September 11. Likewise, he saw the tsunami that destroyed Asia in December 2004 and “quickly began to ponder” its impact on the markets. Like the typical wastrel, Sykes has no feel for the businesses destroyed by short selling, no feel for investors cheated by pump and dump schemes, and no appreciation for investing as a means of saving the product of work for expenditure at a later time. The only thing that saved Sykes from consuming everything he made was his obsessive focus on his own net worth.

Sykes described his book as entertainment. That was not, as I first thought, because Sykes wanted to avoid liability for any trading lesson he might have inadvertently taught in the book becoming a trap for the unwary. Rather, as the closing pages of the book reveal, he now thinks of himself as a mini-celebrity and as a sort of financial entertainer. He has tried to cloak himself with a cause: freedom of speech for hedge fund managers (even though with the growth in the industry, it is clear they are not finding advertising restrictions too limiting).

Sykes is a wastrel. For that reason, his book and life is entertaining. But, it is not terribly educational, nor is it any sort of real lesson. I will put his book on the shelf next to The Radioactive Boy Scout, The True Story of a Boy and His Backyard Nuclear Reactor, by Ken Silverstein. They have much in common.

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Massachusetts is cracking down on brokers and other financial advisors who falsely claim to have special expertise in advising senior citizens on their investments. The new regulations, which take effect June 1, will require that such claims of special credentials must be approved by the Secretary of State. You can learn more about the Massachusetts regulations on the website of Secretary of the Commonwealth William Galvin.

When it comes to investments, senior citizens are where the action is. There are 37 million senior citizens (age 65 and older) in the U.S. today. It is estimated that they control 70% of our nation’s assets. Their median household net worth is $108,885. When you consider that that figure includes home equity, most senior citizens are not wealthy people who can afford to lose lots of money due to poor financial advice. What do you do when you are in your 60s or 70s or 80s and lose your life savings? Few things are more reprehensible than an unscrupulous broker or advisor who recklessly plows through a senior adult’s assets.

To say I am skeptical, is probably an under statement. Massachusetts already licenses insurance agents, registered representatives (securities brokers) and registered investment advisors (as do the NASD/NYSE and the SEC). False or fraudulent representations are already illegal. Investment recommendations that are unsuitable for the elderly or exceed their fragile risk tolerance is already illegal. How will a second license or second level of credentialing help?

Massachusetts would be better off protecting the elderly by restricting surrender charges to two years on products sold to persons after their 70th birthday, prohibiting sales of products to married persons over 70 that do not automatically include a right of survivorship, and doing more to educate licensed persons about and set standards for risk tolerance for persons above the age of 70. For example, people over 70 do not belong in over concentrated portfolios. I often see instances where older and elderly people have been over sold growth and aggressive growth products, sometimes overlapping products, and then the issuer, the broker – dealer or the sales person forget the client exists and does not review positions annually or rebalance the portfolio. Down side risk only seems to matter after a major market correction.

There are too few enforcement actions by states and Massachusetts is hardly leading the way. Most state regulators do not have to commence a forfeiture proceeding against a licensee; the regulator can simply look at a situation, and call the issuer’s general counsel, and advise them they have thirty days to solve the problem. Most issuers will leap at the opportunity to avoid a public announcement of an enforcement action based on sales practice violations practiced on the elderly.

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